ABSTRACT

Foreign aid represents an important source of finance in most countries in sub-Saharan Africa (SSA), where it supplements low savings, narrow export earnings and thin tax bases. In recent years the donor community has become more stringent about fiscal discipline and good policies, which has led to freezing of donor funds to governments that do not conform with aid conditionalties.The objective is to determine the relationship between the foreign aid and the public expenditure ,the trend and growth rate of foreign aid and the trend and growth rate of the public expenditure. The Kenyan government has experienced such aid cuts in the past and this paper uses a welfare utility maximization function to explore how government expenditure responds to fluctuations in aid flows. The empirical results indicate that the flow of foreign aid does influence government spending patterns. There is a positive and statistically significant relationship between the share of government expenditure in gross domestic product (GDP) and the share of net disbursement of overseas development assistance (ODA). While the study finds relatively little evidence that aid leads to tax relief, there are strong indications that the government renders aid fungible by financing recurrent

expenditures. The effects of an aid freeze are strong in the short term as the Treasury embarks on

stringent fiscal measures to counteract the negative effects.

Background

CHAPTER ONE

INTRODUCTION

While developed countries themselves are struggling in financing their budget deficit, developing countries depend highly on foreign aid to finance their expenditure. In the past, developing countries received huge external aid flows from the donor community aimed at promoting economic growth and reducing poverty. However the flow of this aid has never been easily predictable with instances of total freeze (like the case of Kenya 1991 & 1997) and at times minor suspensions (Kenya 1982). Of interest is therefore the study of the responses of respective developing countries in terms of fluctuation of their total expenditure to the fluctuations of foreign aid. These countries sometimes face major budgetary constraints and use aid inflows (based on the previous aid disbursements and current commitments) to cover any deficits vvithin the exchequer.